They were mine before

I gave her one, they gave him two,

You gave us three or more;

They all returned from him to you,

Though they were mine before.

--Lewis Carroll, Alice in Wonderland

That's how I felt when I read today's top news. JP Morgan held $17 billion in cash for Lehman, billions that might have kept the company afloat had JP Morgan not "frozen" the funds. But Lehman owed JP Morgan $23 billion, while JP Morgan held $188 billion in liquid assets for Lehman, until Lehman's filed for bankruptcy with a debt of $618 billion. And that's why taxpayers have to pay $700 billion just to clear away the debris (no one thinks the investment will rebuild the castle). It's enough to make your head spin off.

The amazing thing about all this is the leveraging. These companies were leveraged 30 to 1--meaning for every dollar they invested they borrowed 30. When values rose, they made out like bandits. When values dropped, like underwater homeowners, they had to scramble and hope the banks didn't call in the loans. For a pretty good description of leveraging, check out Andy's post over at Shine on Yahoo. And for a detailed description of the effect of leveraging on the current Wall Street crisis, this from Martin Hutchinson's September 15th column on The Bear's Lair:

Investment banks traditionally had a leverage limit (total assets to shareholders’ equity) of about 20 to 1. That limit was fudged to a certain extent with subordinated debt, but fudging was limited by investors’ unwillingness to buy subordinated debt of such intrinsically unstable institutions. However, while investment bank assets traditionally consisted of commercial paper, bonds and shares that trade every day and can be valued properly, they have now come to include investment real estate, private equity stakes, hedge fund positions, credit default swaps and other derivatives positions that do not even appear on the balance sheet. Thus even 20 to 1 in modern market conditions is excessive.

Adding in subordinated debt, and claiming that say Lehman has an “11% capital ratio” works fine in bull markets, but not when things get tough. Scaling that 20 to 1 up to 30 to 1, as Lehman had at its November 2007 year-end, is asking for trouble. Even if the off-balance sheet credit default swaps and other derivatives don’t lead to problems, and there are no assets parked in “vehicles” that have to be suddenly taken back on balance sheet, an institution that is 30 to 1 levered needs to see a decline of only 3.3% in the value of its assets before its capital is wiped out. Such a decline can happen frighteningly quickly – it represents only a 10% decline in the value of a third of the assets. ...

The commercial banks are not as leveraged. At the latest quarter-end, Citigroup was the most leveraged at 15.4 times, JP Morgan Chase 13.3 times, Wells Fargo 12.4 times, Wachovia 10.8 times and Bank of America 10.5 times. That more modest leverage is the advantage of proper regulation. Even Fannie Mae and Freddie Mac, who benefited from a quasi-state guarantee and were dubiously regulated since they held a stick over their regulator in the form of the Congressional Democrat power structure, had leverage ratios of only 21.5 times and 29.4 times respectively.

There's plenty of people smarter than me talking about exactly what those assets were that companies bought with all that leverage. Mat Miller over at TheDeal.com has posted a sad and hilarious chart showing how $600 billion in subprime mortgages metastasized into trillions in failed assets--packaging, repackaging, sale, resale, and adding debt every step of the way.

The rationale for such complexities is credit-risk transfer. The realities: securities and leverage so much bigger, more complicated and detached from actual assets that value itself became an abstraction. Writes Mizen: "Investors are far removed from the underlying assets both physically (due to the global market for these assets) and financially (since they often have little idea about the true quality and structure of the underlying assets several links back in the chain)."

Where do we go from here? Well, reduced leveraging sounds good to me, accompanied by requirements that keep loans and their risks closer to home, and an end to the "off balance sheet" assets that hide both the extent of the leveraging and the value of the assets purchased with all that borrowed cash. There are some lessons we once learned when we first purchased a home that Wall Street would do well to re-learn.

• If I have to make a higher up front investment in the asset (less leverage) then I am going to be motivated to make a more careful evaluation of its value.
• If the value of my asset is updated annually and publicly posted (in my town, appraisal data is readily available online) then I can keep track of the value of not only my own investment but also all similar investments (the houses around me).
• If I dispute the appraised value of my asset (say because it will cause my taxes to go up), then I can bring evidence to a government arbitor to establish the value that I think my asset has.
• And when values are falling, I can decide early that I want to bail, or more likely I can decide to simply hold onto my asset until times are better. I can do that because I am not highly leveraged (or "under water"), so the bank isn't going to be coming for my house.

This was not the first real estate bust, and it won't be the last. Rather than again following the same Wall Street geniuses who increased leveraging to unsustainable levels and brought us off-balance-sheet derivatives like the credit default swap, we need to return to some first principles--transparency, responsibility, and reasonable limits on the amount of debt anyone should assume. And we've now realized, far too late, that companies won't take responsibility for their actions or choose the path of long term stability over short term gain on their own. We're going to need regulation for that.

It only took six years

The now defunct Glass Steagall Act addressed the causes of the Great Depression by separating banks that hold deposits (and therefore should be cautious about our money) from investment firms that make a buck by offering higher profits to investors (by taking more risks). Check out this PBS page for a very good summary of its slow demise. From the final hatchet to the beginning of the end for the country's biggest banks, it took only six years.

It was a simple principle, and it was abandoned slowly over many years, but finally once and for all at the end of 1999. By the summer of 2006, the housing market began to fall, and all those risky investments started to take down our largest banks. Perhaps on the list of places to go from here, we look at places we've been before and remember what we liked about them.

I'm sticking my head out the window too

From Housing Panic the question arises, are we mad as hell yet?

You didn't change, but your bank says you did

Did you know that your bank can decide, based on factors unrelated to your payment history, that you are now a higher risk borrower and jack up your rates? Yes, they can. Some banks started a round of rate increases early this year and it looks like that trend may continue.

From today's Christian Science Monitor special blog, Global Credit Crisis, we get this:

“Credit markets seem to be dropping for a significant number of customers, especially those with riskier credit,” he says [quoting Bill Hardekopf of LowCards.com]. In addition, he has noticed that credit card companies seem to be reclassifying their customers downward. An individual considered to be an excellent credit risk may be downgraded into a “good” category. “So instead of getting the 8.99 percent rate that was advertised, instead they get the 10.99 percent rate,” he says.

What Mr. Hardekopf didn't make clear is, they can do this not just when you apply but at any time, because of specific clauses in your credit card contract that allow them to. Basically, the banks need money, and you may have some, so they are increasing their charges and you just have to pay...kind of like the bailout. We didn't cause it, but we just have to pay for it.

From USA Today back in February when this all started:

"Banks will want to make up that income somewhere," says William McCracken of Synergistics Research, a research firm. "They're going to be much more aggressive. Everyone is going to see some (price) increase unless they have perfect credit."

By raising rates and fees — but not boosting them so high that they push borrowers into default — lenders are seeking a "delicate financial balance," says Robert Manning, a finance professor at Rochester Institute of Technology. "They can't squeeze too hard that they're going to kill their client. But they have to squeeze more revenue out of their current portfolios."

So where do we go from here? Do we just let the big banks charge us more and more until we can't make our payments and then really do become a "bad risk"? Or do we say, no more.

Interestingly, there's a multi-agency rule pending that would stop this practice and make our contractual agreement with our own credit card banks more meaningful. The new regulation also proposes to stop credit card companies from allocating all of our payment only to the lowest interest balance while interest charges on the higher interest balance rack up.

The official comment period is over, and this rule could be approved as early as year's end, except that so much other business has suddenly piled up on regulator's desks. If you want to remind them to finish this rule because this is the kind of common sense regulatatory reform that actually helps real people, you can email them here.

Let's not go there in secret

Congress has now finally passed HR 1424, a scandalously large taxpayer bailout for Wall Street firms.

Flogged by the punditocracy as an absolute necessity to save the economy, the ink had barely dried under Pelosi's fingers before it became clear that the bailout would not stop continued declines in an economy that is now more than a year into its deepening recession. The slowdowns across the housing sector, which started back in 2006, continued this week, and Labor announced 159,000 fewer jobs, the largest job loss in five years. Ingraciously, stocks failed to rally upon passage of the bill, taking another jolting dive instead.

The bailout package may turn out to be not so much a step towards recovery as another big step down the same road that got us into this mess in the first place. The basic idea that we can throw money at the problem, while charmingly American in its simplicity, may lead instead to a devalued dollar. New provisions reportedly added to garner Republican House votes authorize the SEC to suspend regulations requiring companies to report the market value of assets on their balence sheets. Because things we don't know, we can't talk about. And if we don't talk about it, it will just go away. Or something like that.

James Grant, in a Washintgon post column dated tomorrow, nails the point.

Low interest rates, easy money and malleable accounting rules are what plunged Wall Street into crisis. Yet it is low interest rates, easy money and malleable accounting rules that top the list of federal fixes. The unifying theme of the new bailout bill, all 451 pages of it, is the hair of the dog that bit you.

He is especially skeptical of the move to immediately stop telling the public how much things are, or are not, worth.

Prices can be unwelcome pieces of information. When an especially unwelcome batch wells up after a financial collapse, governments try to quash it. So it is today. The SEC has suppressed short selling. The bailout bill will open the door to the suspension of market-value accounting. The Fed is moving heaven and earth to cheapen the value of the dollar.

Long after the crisis burst into the open, the Fed and Treasury downplayed it. It was, they insisted, "contained." Last week they asserted that, unless the House voted "yea," the wheels would come off this $14 trillion economy. President Bush himself has broadly hinted that the nation is on the cusp of disaster.

How can they be so sure? And how can they know that the unintended consequences of the radical policies they are pushing through won't be worse than the panic that they themselves are helping to foment? When the Fed insists it has no choice but to print up hundreds of billions of new dollars and when the keepers of accounting standards bend in the face of criticism that market prices hurt, what they are really saying is the that financial truth is too awful to bear. Heaven help us all if they're right.

So, what is to be done? Well, first of all, let's start doing a lot of things differently. It is time for more transparency, not less. More accountability, not less. And a regulatory structure that provides real incentives for managing risk effectively at every level of our economy--from the average family to the local business to the bank.

There are models for such effective regulatory approaches. Interestingly, the first model may well be the much maligned Community Reinvestment Act--now taking center stage as the new punching bag for free marketers looking for someone besides themselves to blame. Thanks to Barry Ritholz over at The Big Picture for this quick takedown of that absurd line of reasoning.

But there's an aspect of the CRA that has been essential to its success that he fails to mention. Banks made good loans to good people in underserved markets in large part because the CRA required public reporting of lending patterns and encouraged people in local communities, informed by the data it made available, to participate in the regulatory process and make sure their needs were served.

Contrast that with this:

On April 28, 2004, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks....

On that bright spring afternoon, representatives from the investment banks asked the S.E.C. to exempt their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments.

Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

According to the Times, only one member of the public commented on the proposal, a risk management expert from Indiana, who wrote a two page letter opposing the change and never heard back from any regulator. The meeting was sparcely attended. No major media covered it. So much for taking our cues from the industry we need to regulate, and doing so without a real public debate. It gets us a mortgage crisis, followed by an economic crisis, followed by a taxpayer bailout. Let's not let it be followed by more of the same.